Investing in Futures and Options Essay Example for Free

Investing in Futures and Options Es gradeINTRODUCTIONOf late, investors who argon in the expect and commodity atomic number 18 rivet their attention towards risk attention especially due to towering capriciousness nature.Since these volatility movements are un certain(prenominal), it has become fore just about cause of vagueness for such investors. Since the globalization of administer and free trade amongst major countries has become the order of the day, all most all the investors have to be at a lower place mercy of the qualify charge per unit fluctuations which results in volatility .The notion that exchange grazes , profitability and other factors influence a firms comfort and therefore the hurt of its transmit certificate is widely held by financial analyst ,economists and corporate managers . The liberalization of economic policies and investment policies due to human creations trade organizations (WTO) free diminish of investments and trade between me mber countries and bilateral free trade accordances between countries have appended internationalization of economic activity and exceptional era of world wide silver and reside rates instability. To counter these financial risks, pertly pi mavenering concept commodity and stock commercialize hedging techniques have nurtured at a rapid speed. The main feature of the using derivatives through hedging is to have control over the financial risk and minimizing the effect of uncertain cash flows. financial institutions have come to rescue to these corporations who have expo original to financial risk with the range of products to assist in risk management. By far the most important event in finance during the past decade has been the extraordinary development and expansion of financial derivatives. These instruments enhance the ability to differentiate risk and allocate it to the investors most able and testamenting to take it a process that has undoubtedly improved national pr oductivity growth and standards of living . Allen Green Span, Chairman, Board of Governors of the US federal Reserve System.The structural advantage of derivatives i.e. leverage or gearing makes them suitable for managing risk put up also result in the generation of leveraged profits or in the event of adverse market movement , a significant losses. The main advantage of gearing is that the emptor or seller need plainly to cough up a small proportion of total legal injury at the time of deal is executed.It whitethorn be 1% and 8% depending upon the volatility of the inherent commodity or instrument. In the case of exchange traded transactions, this deposit is recognized as initial margin and is expected to reflect the amount by which the hurt of a bargain may vary in one days trading. At the day end, all contracts will be wanted and if the impairment has been found to move against the position, the losing party will have to pay further variation margin vociferations. In c ontrary, if the de shapeine movement is positive, credit will be given to the party .It is this element of gearing that provides the opportunity to make large gains or losses.Prudent handling of this leverage will result in considerable profit maximization and if it handled inexpertly, may generate losses .In some cases , these losses though high but they are few in occur when measured against volume of business and number of participants in derivative business .The contributory factors for sustaining loss includes excessive position taking ( in relation to capital) , fraudulent activity , unexpected market moves, ineffective risk management, insufficient product understanding and inadequacies in corporate policy governing their use. What is a derivative?differential gear is a mathematical word which refers to a variable, which has been derived from other variable and they have no look upons of their own. deriveds derive their value from the value of some other asset, which is referred as the underlying.For instance, a derivative of the deals of AT T Corporation (underlying), will derive its value from the share equipment casualty (value) of AT T Corporation. Likewise, a derivative contract on wheat depends upon the damage of wheat.An agreement or an weft to buy or sell the underlying asset of the derivative up to a certain time in the emerging at a pre decided monetary value i.e. the exercise price by way of special contract is known as derivative contract.The contract also has a flat expiry cessation mostly in the range of 3 to 12 months from the date of origination of the contract. The price of the underlying asset and the expiry finish of the contract determine the value of the contract.Financial derivatives comprises of underlying financial asset like currency, debt instruments, equity shares, share price mogul etc.Exchange-traded derivatives are derivative contracts that has been standardized and traded on the stock exchanges. Over-the co unter derivatives is one which has been customized as per the requirements of the user by negotiating with the other party involved.Some of the coarse forms of derivatives are Futures, Forwards and Options. FuturesFutures are the derivative contracts that give the holder the chance to buy or sell the underlying asset at a pre-specified price some time in the near next and usually thy come with standardized form like contract size, doctor expiry time and price.The future market is one where continues auction market and exchanges presenting the recent information about the supply and demand as regards to individual commodities or financial instruments like stocks . In other words, future market is one where buyers and sellers of variety of commodities, financial instruments get together to trade. The main aim of the future market is to manage price risk.The future price risk is averted by buying or selling futures contract, with a price train arrived at now, for items to be delive red in future. This is achieved by hedging which helps to shell against the risk of an adverse price change in the near future or use of futures to lock in an acceptable margin between their leverage and their selling price.In futures, bankers, farmers, traders, manufacturers will arrange for the purchase or sale of a futures contract. In future market, commodities are broken down into five categories videlicet agriculture, metallurgical, interest bearingassets, jndexes and foreign currency.Agricultural futures market includes oats, corn , wheat , soybeans , soy meal ,soyoil,sunflower oil ,cattles , live hogs and pork bellies, lumber , plywood ,cotton, coffee, cocoa, rice, orange succus and sugar. For every one of these commodities, different contract months are available and it depends upon the harvest cycle. More aggressively traded commodities usually have more contract months available and a new type of contract is available almost every month to meet the growing institutional and corporate market.Futures on Metallurgical ProductsPetroleum products and metals is being covered under this group and it includes platinum, gold, silver, palladium, copper, gasoline, crude oil, propane and heating oil. Every month a new type of contract emerges to cater the needs of ever sum up institutional and corporate market.Assets which bears interest This has its origin during 1975 and products in these categories include treasury bonds, Treasury Bills, Municipal Bonds, Treasury Notes and Eurodollar deposits. It is also possible to trade contracts with the like maturity but different expected interest rate differentials.Futures on IndexesNow futures are available on most chief indexes such as bare-ass York Stock Exchange Composite, SP 500, New York Stock Exchange Utility index, Russell 2000, Commodity Research Bureau (CRB), SP 400 Midcap, FT-Se 100 Index (London) and Value line. These stock index features are settled in cash and there is no delivery of goods is involv ed in this order. A trader has to settle his positions by buying or selling an offsetting position or in cash at expiration.Foreign Currency FuturesDuring the post war period, the exchange rates and interest rates were durable and the mechanism of fixed exchange rates of the Bretton Woods era enabled the corporations to know in advance their foreign exchange liabilities for their imports.But the collapse of Bretton Woodss system after the war resulted in the introduction of general floating exchange rates replacing the earlier fixed system. The introduction of floating exchange rates have resulted in large unexpected movements in exchange rates that too in unforeseen directions and magnitudes which affected interest rate movements as the mo webary establishment tried to influence the exchange rates by movements in interest rates. It is to be noted that the forward market in currencies is such(prenominal) bigger than the foreign exchange futures market. Further, there are cross cu rrency futures that are being traded and these includes Deutsch mark / yen, Deutsch mark / French franc. Forwards OptionsForward is other form of a derivative contract but tailored to the needs of the user in terms of expiry date, contract size, and price.These contracts confer the holder the plectron to buy or sell the under lying at a pre-determined price some time in the future .Call option is one where the buyer has given his option to buy the underlying at the near future .Where as an option to sell the underlying at a specified price in the future is called as Put Option. As regards to the option contract, the buyer is not obliged to exercise the option contract. Generally, options can be traded on the stock exchange or on the OTC.In option, the participants may assume a position in an underlying futures contract at a certain price which is known as exercise or strike price within a grumpy period of time. The price or premium of the option is determined through action mark et trading. SwapsSwaps contract was introduced in 1981 and can be considered as one of the latest financial innovations to manage financial risks. The contracting parties are obliged to exchange specified cash flows at specified intervals under a swap contract. In a nutshell, a swap contract can be defined as a series of forward contracts put together. If the exchange of interest rate payments in one currency for payments in another(prenominal) currency is devised, then it amounts to a currency swap.If the exchange between two parties of interest obligations or receipts in the same currency on an concord amount of notional principal for an agreed period of time is devised, then it is known as interest rate swap. An interest rate swap is an agreement between two parties to exchange interest payments calculated on different bases over a period of time. Under interest rate swap, one party to the contract makes fixed rate payments while the other partys payments are based on a floating rate such as LIBOR.For instance, if a company which has borrowed from a bank at a floating rate (7 m LIBOR) may want to swap that for a fixed rate (7m LIBOR) so that they can cover the risk if the interest rates go up. On one side, they pay 7% (of the agreed notional principal) and receive 7m LIBOR and on the other side they pay 7m LIBOR straight out to repay their loan. Thus they have converted a floating rate loan into a fixed rate loan.The said bank may manages its own risk from the above swap transaction by fundamenting it out with another swap , say by paying 6.95% for 7m LIBOR and thus they earn a profit of 0.5% difference thus avoiding the risk in the interest rate changes .The other different types of interest rate swap areBasis swap For instance, swapping 2m LIBOR for 4m LIBOR. Basic swaps are mostly use by mortgage companies because the get the mortgage payments on periodical basis.Both fixed Currency Swap Both fixed and say fixed $ for fixed Both floating currency swa p 2m $ LIBOR for 4 m Yen LIBOR.Cross Currency Swap fixed for 2m CHF LIBOR.Companies derive more flexibility to exploit their comparative advantage in their respective borrowing markets under currency swaps. Under interest rate swap, corporations try to focus on their comparative advantage in borrowing in a single currency in the swindle end of the maturity spectrum vs. the long end of the maturity spectrum. USES OF DERIVATIVESDerivatives are mainly used for speculation or hedging. For speculation, derivatives offer us leverage.For instance, kinda of buying 5Million bond in the anticipation that its price will rise up, one can buy an option on that bond, which might only damage 2000. The profit chances or opportunities are the same little the price of the option but the risk is much less as the most we can jobless in this deal is the option price ( 2000).For hedging, derivatives let you to seal the price now for a trade in future or at least(prenominal) limits the rise or fa ll of that price. An UK company holding a US bond which is on the verge of its maturity could buy an interest rate option to guarantee the dollar / sterling rate did not diminish the value of its bond.Volatility is regarded as the most precise measure of risk and its return. The great the volatility, the greater the risk and the reward as it is evidenced in the transaction from bull to bear markets. It is to be observed in the bearish market, volatility and risk augment while returns disappear including short selling returns. HistoryThe very prototypical exchange for trading derivatives started by Royal Exchange in London, which allowed forward contract. Likewise, the first future contract was introduced to Yodoya rice market in Osaka, Japan in 1650. Then in 1848, wampum Board of Trade was started to handle futures market of US.Russell Sage, a famous New York financier introduced synthetic loans using the principle of put-call parity. Sage could able to create a synthetic loan by fixing the put, call and strike prices with interest rate poignantly higher than the US usury law permitted.Chicago Mercantile Exchange started International Monetary Market in 1972 which permitted trading in currency futures. The Chicago Board of Trade started first interest rate futures in 1975.Treasury bill futures contract was introduced in 1975 by Merc.The Chicago Board Options Exchange was started in 1973 and there were publications for the first time option pricing model of Fischer Black and Myron Scholes. Chicago Board Options Exchange created an option on an index of stocks which was originally known as CBOE 100 index which later known as SP 100.During 1980, Swaps and other over-the counter derivatives were introduced. It was in 1994, the derivative trade witnessed a series of huge losses and this affected experienced trading firms like Metallgesellschaft and Procter and Gamble. Orange country, California which is the Americas wealthiest city was declared as unsuccessful person due to derivative trading and use of leverage in a portfolio of short -term Treasury securities.DERIVATIVES OR DESTRUCTIVE? A CASE STUDY OF BARINGS, UK. husking Brothers, a British merchant bank went to bankruptcy in 1995 after incurring a whooping loss of 860 million occurred on the Singapore and Osaka derivative exchanges. chip Leeson, the banks star trader and absence of management controls to monitor his activities were the main reasons for this debacle. During the period between 1992 and 1995, Lesson built up positions in futures and options contracts on the Nikkei 225 stock exchange index, which proved highly profitable in the early years.Futures positions were bought by Lesson on the Nikkei index and financed cash calls on them as they fell in value by selling put options on the contract, thereby producing a straddle and thus betting against volatility of the market. Simex derivative exchange in Singapore were used to book the contracts and he run a hedged position o n Nikkei index futures and make money by arbitraging between Singapore and Osaka markets.However he ceased hedging on the purchases made in Singapore and took on risk. Due to unexpected volatility in the market, losses were incurred and these losses in fact exceeded the net worth of Baring Bank .Lesson was later imprisoned for the falsification of records in an attempt to cover up his activities.The rationale of this case law is to elucidate how a bank can face bankruptcy if there is no proper risk management system is in force. The case also establishes the concept of value at risk (VAR) which is a simple method to express the risk of a portfolio. Because of the recent derivatives disasters, end-users, regulators, financial institutions and central bankers are now resorting to VAR as a method to foster stability in financial markets .The case illustrates how VAR could have been utilized to Baring Bank case to warn its management of the risk they were facing in advance. VOLATILITYVo latility has its effect on administered market and it is high when both supply and demand are inelastic and probable to random shocks. According to Rudiger Dornbusch, market always overshoots in reaction to unexpected changes in economic variables.Volatility is a type of market incompetence and it is a reaction to uncertainty and excessive volatility is unreasonable.Volatility in stock and commodity market is represented by sharp changes in prices and inventory directs and level of volatility itself has fluctuated over the time. Changes in future prices, spot prices and inventories are influenced by changes in volatilityVolatility is a determinant of changes in price express in percentage terms without regard to direction especially in stock price and stock index levels , commodities and in financial intermediaries .For example , an add-on from 200 to 201 in one index is as same as the volatility terms to an increase in 100 to 101 in another index , because both changes are 1% an d as this 1% increase is equal to volatility terms to a 1 % price decline .There are four ways to explain the volatility or movement and they are historical volatility , future volatility , expected volatility and implied volatility .historic volatility is an appraiser of actual price variation during a particular period in the past. Future volatility refers annualized standard deviation of daily returns during particular future period basically between current and an option expiration. Expected volatility is an investors forecast of volatility utilized in an option method to gauge the theoretical value of an option. Implied volatility is the volatility percentage that illustrates the current market price of an option and it is the indicator of an options price.Volatility is describe as standard deviation of the yield of an asset and the value of an option always increases with volatility. The greater the volatility, the higher the option chance during its life and convertible to th e underlying asset at a marginal profit and this methodology has been proved in the Black-Scholes linguistic rule. Black-scholes formula yield results during trends and unsuccessful when the market change sign. The implied volatilities are in effect(p) forecasts of future volatility since varying market conditions cause volatilities to change through time stochastically and traditional volatilities can not correct itself to varying market conditions as ghastly .Stochastic volatility contradicts the assumption required by the Black-Scholes model if volatilities do modify stochastically through moment in time, the Black-Scholes method is no longer the correct pricing method and an implied volatility derived from the Black-Scholes formula provides no fresh information.Black-Scholes formula is lacking on certain issues like the oblique volatilities of motley options on the identical stock tend to differ disregarding the formulas hypothesize that a single stock can be correlated with only one value of implied volatility. The Black-Scholes formula mainly ignores the distribution of stock prices in US market. Some studies have revealed severe deviation from the price process fundamental to Black-Scholes formula like excess kurtosis, skewness, time varying volatilities and serial correlation. Further Black scholes deals with stochastic volatility poorly and it relies on impractical assumption that market dickers ceaselessly thereby ignoring institutional constraints and transaction costs. Stock ChartingStock charting is the process of a graphical sequence record enables it easier to dapple the effect of cardinal happenings on imperious securitys price., its functioning over a period of time and whether its trading its higher or its lower or in between these.Traders are very particular in daily, intraday data to forecast short-term price movements. Investors rely on weekly and monthly charts to mark long term trends and movements. Line chart, Bar chart, Candlestick Chart and point and figure chart are some of the examples of stock charting method. Arithmetic and semi-log arithmetic scales are two methods of price scaling used in the stock charting method.When the price range is hemmed within a tight range and used in general for short-term charts and trading. Semi-log scales are useful for long term charts to estimate the percentage movements over a foresighted period of time including large movements. Stock and other securities are estimated in relative terms through tools lime PE, Price/Revenues and Price/Book and as such it will be more useful to analyse in percentage terms. OcillatorThis is an indicator which is calculated by taking 10 day moving average of the difference between the numbers of advancing and defining issues for supercilious given index. An indicator will reflect whether an index is gaining or losing impetus, so the size of the moves is more significant than the level of the current reading. The level of the reading is in fluenced by how the oscillator changes each day thereby dropping a value ten days ago and adding todays value.The scale in moves is also ministrant when it is compared with the divergence from the index price. If the Dow climaxes at the same time, the oscillator peaks in overbought area and suggests a top. Divergence is said to be negative and momentum is declining when index makes a new high but the oscillator fails to make a higher .One can buy if the index declines at this point but oscillator moves into oversold territory. If the oscillator rises above a previous overbought level though the index rises but does not make new heights, it is said to be upside momentum exists to continue the rally. SupportA support level is the price at which buyers are anticipated to enter the market in considerable numbers to take control from sellers. As the market has its track record, when price falls to a new low and then soars, the buyers who ignored on the first low will be persuaded to buy if price returns to that level back .Fearing of missing out the opportunity for the second time, these traders may enter into market in adequate numbers to take control from sellers. As the result, there is a rally strengthening sensitivity that price is unlikely to fall further thereby creating a support level. ResistanceThe price level at which the sellers are anticipated to enter the market in sizeable numbers to take control from buyers is known as resistance level. If price makes a new racy and then move back, sellers who ignored the previous High will be predisposed to sell when price returns to that level back. Fearing of missing the opportunity for the second time, these sellers may enter the market in large numbers to overwhelm buyers. As the result, market perception will be reinforced that price is unlikely to increase higher and form a resistance level. CANDLE CHARTINGIt is a price chart that shows the open, low, the high and close for a stock each day over a specified period of time .It is known as Japanese candles because they used to analyse the price of rice contracts. When the close is higher than the open , the same is represented by an white empty box in the candle charting .When the close is lower than the open , then it is represented by a unharmed black candle ,Colored candles are used to reflect the days volume. Investment strategies in stock and optionsFollowing is the most of common investment strategies for charge investment objectives, financial means and risk tolerance. Despite of market crash in 1929, market break in 1987, market correction in 1989 and though the prices of all securities fell down drastically but broad movement of the market has seen their value steadily increased. One of the strategies is to buy and hold for long the high quality stocks or futures of stock or commodities .The buy and-hold strategy offers one to profit from this long term forward trend of the stock market. Further, dividend investment project offers small investors a painless method of building wealth.Dollar Cost AveragingThis is also a long term strategy and one has to invest in a stock or mutual fund or futures at regular intervals monthly, quarterly or semiannually. The success of dollar-cost averaging relies on consistency of amount invested and the system of the payments so as to minimize pricing and timing risk. The success of the Dollar cost averaging depends upon the following factors.The plan for the investment should be for a long period i.e. from 7 years to 10 years .In the last 100 years, there were about 40 recessions or market corrections or a downswing about every 3 years and If one carry on to invest through about three of these corrections, the profits of dollar-cost averaging tend to be maximized.2 .Investment at regular intervals is most preferred.Investment should be made regularly regardless of the price of the stock.Give preference to high quality of stocks or mutual funds and a company or fund wi th history of habitual dividend payments and possible for capital appreciation is a better choice.One has to make sure that he has enough strength so that he can adhere to the plan through highs and lows and sell out at the peak and thus the money allocated for dollar-cost averaging result in wealth-building funds, not committed funds.i Going ShortAn investor who prefers short i.e. enters into futures contract by agreeing to sell and deliver the underlying at a price and wishes to make profit from declining price levels and thereby selling high now , the contract can be repurchased in the future at a lesser price thus creating a profit for the investor.16.Spreads It involve taking benefit of the price difference between two different contracts of the same commodity and bed cover is believed to be the most conventional forms of trading in the futures market because it is much safer than the trading long / short futures contract. There are different types of spread namely calendar spr ead, inter-exchange spread and inter-market spread. Swing affairIt denotes a technique of placing emphasis on playing the swings in the PPS, selling on the highs and buying on the lows sooner than the swiftness of the trade. To complete the swing trade, it may need more than a day, a week or authoritarian month or longer period and channeling stock is pursued by the some swing traders. FlippingIt refers the process of trading a stock very quickly with in minutes or hours etc as past as possible may be on the same day. It is often used to explain a buy and sell with a share that is running and where the trader buys the stock as it is moving up and sells the same on even a higher point in a short period of time. A flipper aim is to maximize his profits by emphasizing on fast trades to earn quick profits. The risk is also less downside as the trader sits in a stock for a less time.i Hall, Alvin D., and Carolyn M. Brown. 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